Monopsony: the basics, plus policy implications

By Kathy G.

Be honest -- are you skipping all these monopsony posts? Are your eyes glazing over at the mere sight of this odd and hard-to-pronounce word? Well, I hope not.

But in case you are -- and in case the reason for this is that you don't have a clear understanding of what it is in the first place, and why it might be important -- I'll try to remedy that by providing a (hopefully) coherent and straightforward explanation of the concept. Then maybe if you have a better grasp of what monopsony is, you can go back and read the other posts, and they might be a little more interesting to you. I'll also go on to highlight some of the policy implications of monopsony, and why I think it's important not only in an abstract theoretical sense, but in a concrete political sense as well.

The literal meaning of monopsony is "one buyer" (just as the literal meaning of monopoly is "one seller"). In the context of labor markets, monopsony means one buyer of labor, that is, one employer. But that's confusing, because these days when economists use the term in the context of labor markets they usually don't mean one employer.

Here's what they do mean: in the standard labor market model, known as the perfect competition model, the market as a whole -- that is, the supply of labor (all workers seeking a job) and the demand for labor (all jobs being offered by all firms) -- determines the wage. The market-clearing wage occurs at that point where labor supply equals labor demand.

Moreover, in the perfect competition model, no single firm has the power to determine the wage; it simply accepts the wage that the market as a whole has determined, and that is what it offers to its workers. In this model, workers are extremely wage-sensitive, so much so that if any single firm cuts wages by even one cent, all the workers at that firm will immediately quit and find employment elsewhere.

In the monopsony model, however, the theory is that the employer has what is known as "market power," and therefore is not a "wage-taker" (i.e., doesn't have to offer the market wage). In this model, it is assumed that it's the employer, not the market, which sets the wage. Therefore, in the monopsony case, the employer will offer below-market wages. And moreover, it's assumed that the source of the firm's market power are forces that bind an employee to an employer, so that if wages were cut, at least some of the employees would stay.

What are the forces -- or frictions -- that prevent workers from automatically quitting if wages were cut? Frictions include the search costs of getting a new job, incomplete information about what other jobs might be available, mobility costs (the costs of traveling to a new job), personal preferences (such as strongly preferring a certain type of work, or one's co-workers, or a benefit offered by the job), and the firm-specific training and skills that a worker may have.

If you ask me, the monopsony model is clearly a better fit for the way the world works than perfect competition is. The assumptions of the perfect competition model -- complete information, zero mobility costs, employees being so wage-sensitive that they'd all quit even if their employer cut their wages by only one cent -- seem unreasonable (and I say that knowing that, yes, for simplicity's sake, all models have features that seem unrealistic.  Even so . . . ) On the other hand, the assumptions of the monopsony model -- that employers set wages, and that there are important frictions in the labor market -- seem highly plausible, at least in the case of most employment situations.

It's a far more persuasive model, I think, and here's the reason: it models power, in this case, the power that employers have over employees. The Achilles heel of neoclassical economics is that the concept of power is almost never incorporated into its theories and models. And that is just a huge intellectual shortcoming. In the standard labor market model, for example, the employer/employee relationship is seen as symmetric, with neither being more powerful than the other. Each has the equivalent power to terminate the relationship if a better offer comes along. Which is just so wrong, on so many levels.

Monopsony is a useful concept, in part because it explains some interesting, and sometimes puzzing, features of labor markets. For example, in his book, Alan Manning argues that monopsony is the source of part of the gender pay gap. He says that there's evidence that because women often place a higher value than men do on the non-wage aspects of a job, the labor market for women is more monopsonistic (their personal preferences are more likely to keep them bound to their employer). Monopsony may also explain the research that shows that employer characteristics are correlated with wages. Theoretically this shouldn't happen, but it might if, as is the case with monopsony, employers themselves, rather than the market as a whole, set wages.

One of the key take-aways about monopsony is that, when you work out the details of this model and compare it to the perfect competition model, you'll find that wage and employment levels under monopsony are always less than the wage and employment levels under perfect competition. In other words, monopsony labor markets are inefficient.

This has important implications for policy. The bias of most economists is that markets should never be regulated unless they are inefficient. If government intervention can clearly improve efficiency, that's all well and good, but those cases are assumed to be relatively rare. And interventions in markets for equity's sake alone are generally frowned upon. Now I happen to think that interventions that improve equity are just fine, and I strongly support many such interventions. But it's much harder to argue for intervention if it's believed that intervention will reduce efficiency.

However, the assumption of a monopsony shows some government interventions in a new light. For example, in the perfect competition model, the institution of a minimum wage always leads to lower employment. But in the monopsony model, it can actually increase employment (though even in monopsony, if you raise it too high it can decrease employment, too). Monopsony might be the reason why so many (though not all) studies show that the institution of a minimum wage does not decrease employment.

Monopsony theory also has important implications for unions. Under monopsony, and with a few other (very reasonable) theoretical assumptions, the presence of unions is expected to raise nonunion wages. This outcome is not predicted by standard theory.

I hope you can see why I think monopsony is an important concept. It's a better fit for the way the labor markets actually work, and helps to explain many features of the labor market that perfect competition cannot. Moreover, it shakes up the old "let the market work its magic" assumptions about the impact of regulation on labor markets. No wonder why supposedly economics-savvy "free markets are teh awesome" types like Megan McArdle don't understand the concept of monopsony. They don't want to understand it.

(H/T to F., who sent me an email saying he wasn't clear on what monopsony was and asked me to define it for him. I hope this helps!)

Comments

[whitebeard]

Absent from the list of forces, above, which bind workers to the employer or prevent them from quitting automatically if wages are cut is what I think of as the major disincentive and that is: income as well as some possible benefits (e.g. health insurance or child care) drop to zero if the worker quits immediately upon the cut and continue for as long as unemployment continues. This effect has the potential of reputation-threatening (e.g. credit rating), if not life-threatening consequences.

*goes back to reading the post*

[whitebeard]

"But it's much harder to argue for intervention if it's believed that intervention will reduce efficiency."

The key word in that statement is "believed". Employer propaganda or employer religion wants everyone to believe that for it allows them to exercise their superior power more freely.

*returns to reading*

[whitebeard]

It seems to me that oligopsony (few buyers relative to sellers) is, perhaps, closer to what you have in mind here, but I am certain that you are right in your observations about the nature of real markets.

Free market theory in the modern world is simply a shill for business management people who hold power vastly superior to laboring people.

[whitebeard]

"in the modern world"

Better, I think, would be "in the contemporary world".

[Wrongshore]

Could you please now explain how the term "monopsony", which I previously understood as "how to buy alcohol in Pennsylvania", comes to mean "search friction complicates the econ 101 understanding of wages"?

[paine]

the full expression is

monopsonistic competition

there are many firms

but each firm
---for the reasons nicely outlined
above ...(plus others)---- has a wage setting power
ie each firm standing alone
---using st alfred's paradigm---
faces an upward sloping supply curve

the diff
oligopsonistic markets
are few buyer markets
fully aware of each other
as labor buyers in this setting
and thus interacting
players in a wage offer
strategeeeery game

[Noni Mausa]

Thank you for this very clear explication. Not only is it true, but businesses have shown by their actions that they know it's true, too. Take the effort exerted in the US to not only undermine the union movement under law, but discredit it in the popular imagination.

Example: my friend's son-in-law, who steadfastly avoids union positions because the union will "tell him where he can and can't work", and whose actions "force wages up so that jobs disappear." To say nothing of the Hoffa effect.

He is no rich kid who can pick and choose, he's a poor man raising three small children and putting his wife through university, in a province which is desperate for construction workers. He works two jobs but still can't make ends meet.

He could probably raise his personal wage by 50% just by heading down to the union hall, but he is stubbornly contemptuous of unions.

Noni

[Horde]

I've been closely following and reading your monopsony posts. They are fantastic, and I think a very important understanding for both how our economy (and culture) got this way and how to get it out.

One thing to keep in mind, although I would say this clearly does not affect your argument much, is that wages even in a monopsonistic model do respond to the market forces in the case of hiring new employees. Regardless of market power, some employees leave work for a variety of reasons (retirement, pregnancy, moving, frustration, etc.) and these positions have to be replaced and new positions created by any growing firm. To find competent new employees (and in some cases even incompetent ones), employers do have to adjust their wages. They can only make the difference in wages between new and old employees so much before the old employees leave to pursue new opportunities at competing firms. Of course, this results in upward wage pressure only in tight labor markets. This is important to keep in mind because it offers a way out a downward wage spiral to the subsistence wage.

My experience in the working world has been that union negotiations and the desire to recruit new people are the primary forces keeping wages growing.

[David]

Kathy:

While many labor markets do not fit the perfect competition model, it seems that many labor markets also are not well-described by monopsony either. I am not a labor economist, but I suspect most labor markets are somewhere in between these two extremes.

Any thoughts?

[JB]

Awesome. All we need to implement this new monopsony-model-based understanding of labor markets is to bump up minimum wages for all workers. Or at least all workers whose wages should be raised in order to increase equity. (Those below the median? Or the mean? Either way.)

Of course, the right minimum wage might be different for different industries and even different jobs within various industries. But the government will have no difficulties fixing wages here and there, and getting it exactly right so that equity and fairness are improved without anyone losing their job.

This fool-proof plan will certainly usher in a new era of equality and prosperity that will be super bitchin'.

[ninja_zombie]

>In this model, workers are extremely wage-sensitive, so much so that if any single firm cuts wages by even one cent, all the workers at that firm will immediately quit and find employment elsewhere.

This is just so wrong I don't even know where to start.

In perfect competition, each worker is assumed to have a reserve price for his next hour of labor. If this price is not met, he will not work.

Unless the reserve price is exactly $0.01 below his current wage (which it would be for only a very few workers), the worker will not quit.

Monopsony is silly, a much better model would be perfect competition with transaction costs.

[Kathy G.]

Ninja Zombie, sorry, but you're wrong. First of all, one of the problems with perfect competition is that it assumes *zero* transaction costs! Which of course, in terms of the real world, is ludicrous.

And the perfect competition model *very much* assumes that if the firm cuts wages by one cent, *all* -- every last one! -- of the workers at that firm will quit and find work elsewhere. Just look at any labor econ textbook, fer chrissakes! That's what it says. If you don't like it, take that up with the folks who invented the theory. But don't blame me. I swear -- I had nothing to do with it!

[ninja_zombie]

Kathy: you seem to be assuming that *any* violation of perfect competition completely invalidates the theory. In fact, perfect competition is stable w.r.t. most small perturbations (e.g. transaction costs, imperfect information).

As for your textbook, it's correct only in the large N limit (and also at equilibrium). If there are finitely many (but large, e.g. 50+) players, it's still roughly correct, but with some boundary layer of size O(1/sqrt(N)). Relatively small transaction costs, imperfect information, etc, add to the width of this layer.

In laymans terms, those supply and demand curves you see drawn in textbooks are fat and fuzzy. All the economic theory works when your changes are large relative to the fuzziness of the curves, and no reasonable economist would claim otherwise. Your hypothetical $0.01 perturbation is not.

This doesn't invalidate economics, just your interpretation of it.